Unit 7
ADMS 3530 2011-12
Classroom Version
1
Read chapter 8 of your text
2
Unit 6
 Different investment criteria for evaluating projects:
 NPV is the gold standard
NPV = - CF0 + CF1 +
(1+r)1

CF2
+ CF3 … +… CFn
2
(1+r)
(1+r)3
(1+r)n
All variables such as the cash flows (CF’s) and discount rate (‘r’)
were given to us.
Unit 7
 We will identify the cash flows (CFs) used for NPV calculations.
 This process is called discounted cash flow (or DCF) analysis or
capital budgeting.
3
Module 7.1 – Identifying Relevant Cash Flows
Module 7.2 – Basic Steps in DCF Analysis
Module 7.3 - Review of Depreciation and CCA
Module 7.4 - Present Value of CCA Tax Shields
Module 7.5 - Putting It All Together – a DCF Example
Module 7.6 - Summary
4
There are 9 Basic Rules for Identifying Relevant Cash Flows
for DCF Analysis:
Rule 1: Discount cash flows, not accounting profits.

Recognize expenses and revenues as they occur, not later
when they show up for accounting purposes.

You have to be especially careful to ignore non-cash items
such as depreciation and accruals.
5
7.1 Identifying Relevant Cash Flows
Rule 2: Discount incremental cash flows
Incremental Cash flows =
Cash flows with the project – Cash flows without the project
Rule 3: Include all indirect effects


Bad indirect effect  a new product damages sales of the firm’s
existing product.
Good indirect effect  the additional parts and maintenance
revenues that the sale of a new engine would provide to an
aircraft manufacturer
6
7.1 Identifying Relevant Cash Flows
Rule 4: Forget sunk costs

All historical costs are sunk costs and will remain the same
whether the project is accepted or rejected. Therefore, they
should not be included in a project’s cash flows.
Rule 5: Include opportunity costs

Opportunity costs are benefits or cash flows foregone as the
result of going ahead with a project.
Example: the market value (not cost base) of land that is owned
by a company who is evaluating whether or not to build a new
plant, should be included in the DCF analysis.
7
Rule 6: Include the investment in net working capital
Net working capital = short–term assets – short-term liabilities.

Short term assets include cash, accounts receivables and
inventories.

Short-term liabilities include notes payable and accounts
payable.

Investments (or increases) in net working capital (e.g., if
inventories are being increased), are just like investments in
plant and equipment, result in cash outflows.
8
7.1 Identifying Relevant Cash Flows
Example: Net Working Capital
What is the net effect on a firm’s working capital if a new project requires:
 $30,000 increase in inventory, $10,000 increase in accounts receivable,
 $25,000 increase in machinery, and $20,000 increase in accounts payable?
Solution
Change in working capital is:
= increase in accounts receivable + increase in inventory – increase in
accounts payable
= $10,000 + $30,000 - $20,000 = $20,000.
This $20,000 is a net increase which is a cash outflow and must be included
in project analysis.
(Note: the $25,000 increase in machinery is a capital cost - not a working
capital item, and is omitted from the calculation!)
9
7.1 Identifying Relevant Cash Flows
Rule 7: Be aware of allocated overhead costs

You should Include only extra overhead expenses that result from
a project
Rule 8: Discount nominal cash flows by the nominal
interest rate.

If using ‘real” cash flows, discount by the real interest rate.
10
Rule 9: Separate Investment and financing decisions.
 First assess a project as if it were all-equity financed.
 Do not include any interest or debt payments incurred as a
result of project financing. (We will learn the logic behind this
reasoning in Unit 11).
11
7.1 Review Question
Question 1
A firm is considering an investment in a new manufacturing plant. The
site is already owned by the company but existing buildings would need
to be demolished. Which of the following should be treated as
incremental cash flows?
i) The market value of the site.
ii) The market value of the existing buildings.
iii) Demolition costs and site clearance to be incurred.
iv) The cost of a new access road put in last year.
v) Lost cash flows on other projects due to executive time spent on the
new facility.
vi) Future depreciation of the new plant.
A) i, ii, and iii only
B) ii, ii, iii and iv only
C) i, ii, iii and v only
D) All of the above
12
7.1 Review Question
This correct answer is C.
iv) the cost of a new access road incurred last year is a historical or
sunk cost and should be excluded.
vi) future deprecation of the new plant is a non-cash item and
should be excluded.
The other items are incremental cash flows and should be included
in project analysis.
13
7.1 Review Question
Question 2
Allocations of overhead should not affect a project's incremental
cash flows unless the:
A)
project actually increased overhead expenses.
B)
overhead cannot be recovered at the end of the project.
C)
overhead cannot be allocated to other projects.
D)
accountant is required to allocate costs to this project.
Please choose the correct answer.
14
7.1 Review Question
The correct answer is A.
You should Include only extra overhead expenses that result from
a project
15
Step 1. Identify all relevant project cash flows (Module 7.1)
Step 2: Separate the cash flows into 4 main categories:
i. Plant & Equipment (this is usually CF0),
ii. Net working Capital,
iii. Cash Flow from Operations (most difficult part!)
iv. Salvage Value
Step 3: Determine the cost of capital (we will do this in Unit 10)
Step 4: Discount all relevant cash flows
Step 5. Find NPV and if NPV>0 then proceed with the project
16
7.2 Basic Steps in DCF Analysis
Step 2: Finding Cash Flow from Operations (CFop)
Method 1: CFop = revenues – cash expenses – taxes paid
Method 2: CFop = net profit (after-tax) + depreciation
Method 3: CFop = (revenues – cash expenses) × (1 − t) + (depr. × t)
(note: “t” is the corporate tax rate)
All 3 methods will give you the same answer!
17
7.2 Basic Steps in DCF Analysis
Note on Deprecation:
Recall from Module 7.1:

We do not include depreciation in our project cash flows (as it is
a noncash item).

We need to add it back to our cash flow number if we are trying
to calculate our cash flows from accounting income (where it has
been deducted).

However because we are allowed to use deprecation (or CCA) to
reduce our taxes payable, depreciation savings do affect cash
flow and we do have to incorporate this tax savings which is
called the CCA tax shield.
18
7.2 Basic Steps in DCF Analysis
Step 2 Example:
Calculating Cash Flow from Operations
(using accounting data)
Revenues
200
Method 1:
CFop = 200 - 100 - 36 = $64
Cash Expenses
-100
Depreciation
-20
Method 2:
CFop = 44 + 20 = $64
Pre-tax Profit
80
Taxes @ 45%
-36
Method 3:
CFop = (200-100) x (1- .45) + (20 x .45)
= $64
Profit After Tax
44
Note: All 3 methods produce the same answer!
19
7.2 Review Question
Question
What is the amount of the operating cash flow for a firm with
$750,000 profit before tax, $150,000 depreciation expense, and
a 35% marginal tax rate?
A) $262,500
B) $487,500
C) $554,500
D) $637,500
Please choose the correct answer.
20
7.2 Review Question
The correct answer is D.
Method 2: CFop = net profit (after-tax) + depreciation
= $750,000 x (1 - 35%) + $150,000
= $637,500
21
Depreciation
 a non-cash expense that reduces the value of an asset as a result
of wear and tear, age, or obsolescence.
 Reflects the declining value of their assets over time.
CCA - Capital Cost Allowance
 a specific type of depreciation expense that the CRA allows
when businesses calculate taxable income (and hence their tax
returns).
 There are over 30 categories or CCA asset classes.
We will use the terms CCA and depreciation interchangeably from
this point on.
22
7.3 Review of Depreciation & CCA
NOTE:

Although CCA itself is a non-cash charge, it does affect cash flow
to the extent that it reduces taxes paid Those tax savings
must be included in the capital budgeting decision.

This tax savings is also called the CCA tax shield or depreciation
tax shield.
23
7.3 Review of Depreciation & CCA
There are two main methods of calculating CCA and accounting
depreciation:
1. Straight-line Depreciation
2. Declining Balance Depreciation
1. Straight-line Depreciation
 assumes the asset will lose an equal amount of value each year.
(except for the half-year rule, which we will discuss shortly)
 = [Purchase Price – Salvage value] /est. useful life of the asset
 It is essentially an annuity series – in that the same dollar
amount of depreciation is expensed each year,
 Used for leasehold improvements, patents, and a few other
assets classes
24
7.3 Review of Depreciation & CCA
2. Declining Balance Depreciation

used for most asset classes

the same percentage is applied to the undepreciated asset
value.

= the Class % rate x the Declining asset balance amount
(see p.253 text)
Note: you will be told in the problem whether you have to use
declining balance or straight-line deprecitaion.
25
7.3 Review of Depreciation & CCA
Other CCA terms:
Half-Year Rule

In an asset’s first year of purchase, only one-half of the purchase
cost can be used to calculate CCA (regardless of what part of the
year the asset was purchased).

This rule was designed to stop companies from purchasing assets
in December and then expensing CCA for the whole year.
26
7.3 Review of Depreciation & CCA
Other CCA terms:
A company is entitled to CCA as long as it owns at least one
asset in the asset class.
Q: What happens when the company disposes of its entire pool of
assets in that asset class?
A: We end up with Terminal Loss or Recaptured Depreciation
(but you do not need to know these terms for this course!)
27
7.3 Review of Depreciation & CCA
Depreciation – Example 1
 We need to include the tax savings
or the CCA tax shield in DCF
Analysis:
With depreciation (CCA)
Revenues
100
Cash Expenses
-50
Depreciation (CCA)
-20
Pre-Tax Profit
Note the firm’s Net Profit after Tax
is higher ($30 versus $18) when it does
not have depreciation.
Income Taxes @ 40%
Profit After Tax
30
-12
18
With no depreciation
Revenues
100
Cash Expenses
-50
Pre-Tax Profit
Income Taxes @ 40%
Profit After Tax
28
50
-20
30
7.3 Review of Depreciation & CCA
Depreciation – Example 1
Cash Flow OP calculation (method 1)
Note when we calculate CFop, where we
have depreciation, the Cash Flow
number is higher ($38 versus $30).
This is because the depreciation
expense (although a non-cash items)
‘shields” our income from taxes
(which are a cash number).
This savings in cash taxes payable ($20$12 = $8) is called the depreciation or
CCA Tax Shield.
It can be calculated using a short-cut
formula, as shown in the next slide
With depreciation (CCA)
Profit After-Tax
18
Cash Expenses
-50
Income Taxes paid
-12
Cash Flow op
With no depreciation
Revenues
Cash Expenses
Income Taxes paid
Cash Flow op
29
38
100
50
-20
30
7.3 Review of Depreciation & CCA
The value of the CCA Tax Shield in any one year:
= CCA Amount x Tax rate
In the previous example, the CCA tax shield in year one is
= $20 (the CCA amount) x 40% tax rate
= $8 in taxes is saved because of depreciation.
Be careful! Do not mix up the CCA amount and CCA Tax Shield
30
7.3 Review of Depreciation & CCA
Example 2: CCA Tax Shield
You are considering investing in a piece of equipment. The equipment
has an initial cost of $125 and belongs in a 20% CCA class. Assume a 34%
tax bracket and a salvage value of zero. The half-year rule applies. What
is the value of the annual CCA tax shield for year 2 of the project?
Solution:
Year
Net Acquisition
UCC start
CCA Amount
1
$125
125.00
12.50
2
$0
112.50
22.50
UCC end
112.50
(1/2 yr rule!)
90.00
However, we are not finished yet!
CCA tax shield (tax saving ) in year 2 = CCA2 x tax rate
= 22.50 x 34% = $7.65
31
7.3 Review Question
Question
Jensen Industries is considering purchasing a new Drilling Press.
The press costs $100,000, and belongs to a 15% CCA rate asset
class (declining balance method) and the half-year rule applies.
If the tax rate is 40%, what is the amount of the CCA tax shield in
year 1?
A) $3000
B) $6000
C) $7,500
D) $15,000
Please choose the correct answer.
32
7.3 Review Question
The correct answer is A.
The amount of CCA in year 1 is 15% x $100,000 x1/2 = $7,500
The CCA tax shield for year 1 = $7,500 x 40% = $3,000
33
So far we have calculated:
CCA tax shield for a single year but most projects we will last many
years.
 We will have a tax shield or tax saving for every year of the
project.
 And we have to discount these tax shields.

So….we need to calculate the present value of all the CCA tax
shields over the projects’ life, or the
PVCCATS (Present Value of the CCA Tax Shields)
34
7.4 Present Value of CCA Tax Shields
Recall from Module 7.3 - 2 main methods of calculating depreciation
1.
Straight-line
2.
Declining balance.
(The method used will depend on which asset class the asset you are depreciating
falls into.)
Calculating PVCCATS:

Straight-line depreciation is easy -> finding the PV of an annuity!

Declining balance depreciation – much more complicated!
35
7.4 Present Value of CCA Tax Shields
Example 1- Finding PVCCATS for Straight-line depreciation
Calculate the annual depreciation and PVCCATS for an asset
(such as a trademark) costing $200,000 and a $20,000 salvage
value at the end of year 10. The asset falls into a straight-line
depreciation class. The firm has a 40% tax rate and a 12%
discount rate. The firm’s project is expected to last 10 years.
Solution:
Ignoring the half-year rule, the annual amount of CCA expense is
= $200,000 - $20,000 (Salvage value)/10 years
= $18,000 every year
And the annual CCA tax shield is:
= $18,000 x 40% or $$7,200.
36
7.4 Present Value of CCA Tax Shields
Example 1- Finding PVCCATS for Straight-line depreciation (cont.)
Ignoring the half-year rule!
Annual CCA amount = $18,000
Annual CCA tax shield = $7200
we are dealing with an annuity.
Now find PVCCATS:
Using your calculator:
PMT = $7,200, - =12, n=10, FV=0, COMP PV  PV = $40,681.16
This is the PV of the CCA Tax Shields over the project’s life.
37
7.4 Present Value of CCA Tax Shields
Example 2: Finding PVCCATS for Declining Balance Method
Calculate the annual CCA amount and PVCCATS for an asset costing
$200,000 and a $20,000 salvage value at the end of year 10. The asset
falls into a 10% declining balance depreciation method class. The firm has
a 40% tax rate and a 12% discount rate. The firm’s project is expected to
last 10 years.
This table just shows the CCA amount and the CCA tax shield for only the
first 2 years (remember we are ignoring the half-year rule) for simplicity!
Year
1
2
UCC start
200,000
180,000
CCA @10%
UCC end
20,000
18,000
180,000
162,000
CCA tax shield
(CCA x 40%)
$8,000
$7,200
Note: The annual CCA tax shields are different! (not an annuity series).
To find the PV of the tax shields over many years, we have a shortcut!
It’s called the PVCCATS formula!
38
7.4 Present Value of CCA Tax Shields
If you have declining balance method of CCA:
The PVCCATS =
[
CdTc 1  0.5r
SdTc
1
][
] [
][
]
t
r  d 1 r
d  r (1  r )
where:
C = capital cost of an asset acquired at beginning of year 1
d = CCA rate for the asset class to which the asset belongs
Tc = corporate tax rate
r = discount rate
S = salvage amount from the sale of the asset at the end of year t
Note: do not mix up “d” and “r” !
And yes! This is a shortcut to having to work out each year’s CCA and the
present value of each year’s CCA!
39
7.4 Present Value of CCA Tax Shields
Example 3: Calculating PVCCATS for a declining balance asset
What is the PVCCATS for a firm with a 10% discount rate and in
the 35% tax bracket if it purchased a $50,000 asset and the CCA
rate is 15%? The half-year rule applies and assume no salvage
value.
Solution:
First identify your variables:
d= 0.15
r = 0.10
Tc = 0.35
C = 50,00
S=0
40
7.4 Present Value of CCA Tax Shields
Solution Example 3:
First identify your variables and then input them into the long
PVCCATS formula as shown below. (Note if S=0, the second half of
the equation goes to zero!)
PVCCATS =
[
CdTc 1  0.5r
SdTc
1
][
] [
][
]
t
r  d 1 r
d  r (1  r )
PVCCATS = {[50,000 x .15 x .35] / (.10 +.15)} x [(1 + .5 x .10)/(1.10)] - 0
= [ 2,625 / 0.25]
x
= 10,500
0.954545
x
[1.05 / 1.10]
= $10,022.73
41
7.4 Present Value of CCA Tax Shields
Q: Why we have to calculate the PVCCATS?
A: It is one of the cash flows affecting a project’s NPV.
If you have a declining balance asset class, then you will most
likely be forced into Method 3 of calculating CFop as we saw in
Module 7.2:
CFop = (revenues – cash expenses) × (1 − Tc) + (CCA × Tc)
Where (CCA × Tc) = CCA tax shield and you need to calculate the
PV of these tax shields (the PVCCATS) when calculating the
project’s NPV!
42
7.4 Review Question
Question
Jensen Industries is considering purchasing a new printing press
that costs $100,000, and belongs to a 15% CCA rate asset class
(declining balance method) and the half-year rule applies.
Assume there is zero salvage value. The discount rate is 10% and
the tax rate is 40%. What is the present value of Jensen’s CCA
tax shield?
A) $5,367
B) $11,667
C) $19,419
D) $22,909
43
7.4 Review Question
The correct answer is D.
Identify your variables and input them into the PVCCATS formula:
 $100,0000  15 %  40%  1  0.5  10% 
PVCCATS 
 $22 ,909 .




10%  15 %
  1  10 % 
44
Review:
NPV = - CF0 + CF1 + CF2 + CF3 … +… CFn
(1+r)1
(1+r)2
(1+r)3
(1+r)n
This unit  which cash flows (CFs)should be included?
The cash flows can be broken down into 4 categories:
1.
Plant & Equipment,
2.
Net working Capital,
3.
Cash Flow from Operations = CFop (which includes PVCCATS)
4.
Salvage Value.
45
7.5 Putting it all Together – A DCF Example
Review (cont.)
For Cash Flow from Operations, there are 3 methods to calculate it:
Method 1: CFop = revenues – cash expenses – taxes paid
Method 2: CFop = net profit (after-tax) + depreciation
Method 3: CFop = (revenues – cash expenses) × (1 − Tc) + (CCA × Tc)
Notes:
1.
These formulas just give us CFop for a single year and we must take the
present value of each annual CFop to find NPV for the project.
1.
If we have declining balance depreciation then we are usually forced
into Method 3 where we calculate CFop without depreciation and then
add back the depreciation tax shield separately.
46
7.5 Putting it all Together – A DCF Example
Comprehensive Example – DCF Analysis
Bleeper Industries is considering a project which costs $100,000
and produces after-tax operating cash flows (excluding CCA tax
shields) of $23,000 per year for six years. The project requires a
$5,000 increase in net working capital in Year 0; the working capital
is recovered in Year 7, one year after the end of the operating cash
flows. The CCA rate is 15% (declining balance method) and the halfyear rule applies. Initially assume there is zero salvage value. The
discount rate is 14% and the tax rate is 40%.
47
Comprehensive Example – DCF Analysis
A) What is Bleeper’s total cash flow in Year 0, excluding CCA tax
shields?
Solution: CF0 = -100,000 -5,000 = -$105,000
(Note: both the outlay for the project and the increase in net working capital must be
included for year 0.)
B) What is Bleeper’s CCA in Year 1?
Solution: CCA amount in year 1 = 100,000 x 15% x ½ = $7,500
(Note: don’t forget the half-year rule!)
48
7.5 Putting it all Together – A DCF Example
Comprehensive Example – DCF Analysis (cont.)
C) What is the present value of Bleeper’s operating cash flows,
excluding CCA tax shields?
Solution:
We are dealing with an annuity and can use our calculator to solve:
Input; PMT = $23,000, n=6, i=14%, COMP PV  PV= $89,439.35
Note: in this example our CFop ($23,000) were already after-tax so we did
not have to adjust them for taxes.
49
7.5 Putting it all Together – A DCF Example
Comprehensive Example – DCF Analysis (cont.)
D) What is the present value of Bleeper’s working capital recovery,
which occurs in Year 7?
Solution:
We will recover the $5000 increase in net working capital at the
end of year 7,
PV working capital recovery = 5000
(1.14)7
= $1998.19
50
7.5 Putting it all Together – A DCF Example
Comprehensive Example – DCF Analysis (cont.)
E) What is the present value of Bleeper’s CCA tax shield?
Solution:
Since we are dealing with a declining balance asset class, we
have to use the long PVCCATS formula:
Where PVCCATS =
[
CdTc 1  0.5r
SdTc
1
][
] [
][
]
r  d 1 r
d  r (1  r ) t
= $19,419
51
7.5 Putting it all Together – A DCF Example
Comprehensive Example – DCF Analysis (cont.)
F) Should Bleeper accept the project?
Solution:
Now we put all of our discounted cash flows together:
->Initial outlay + PV [CFop] +PV[working capital recovery] + PVCCATS
NPV = -105,000 + 89,439.35 +1998.19 + 19,419 = $5,865.54
Since NPV > 0, yes! Bleeper should go ahead with the project.
52
7.5 Putting it all Together – A DCF Example
Comprehensive Example – DCF Analysis (cont.)
G) By how much will the NPV increase if Bleeper is able to obtain a
$10,000 salvage value at the end of Year 6? (instead of zero)
Solution:
Salvage comes into play in 2 ways!
1. The salvage value received at the end of the project is a positive cash
inflow which must be discounted back to time zero.
PV Salvage Value = 10,000 / (1.14)6 = 4,555.87
2. Since S is no longer zero, we must recalculate the PVCCATS formula
New PVCCATS = 19,419 – 942.59 =18,476.41 (try it yourself!)
NPV will change: 4,555,87 + (18,476.41 - 19,419)= $3613.28 increase in
NPV.
53
7.5 Review Question
Big Question!
Your firm is considering investing in a supercomputer to implement a
new revolutionary web service. The pre-tax cash flow (excluding CCA tax
shields) is expected to be $18 million for each of the 10 years of the
project's life. The equipment has an initial cost of $85 million and
belongs in a 45% CCA class. Assume a 30% tax bracket, a discount rate of
12%,and a salvage value of $35 million. We assume that the firm will still
have equipment in the same CCA class and that the half-year rule
applies. What is the project’s NPV?
A) $11.27 million
B) $13.85 million
C) $31.24 million
D) $71.19 million
54
7.5 Review Question
The correct answer is B!
1. The PV of the after-tax cash flows (excluding CCA tax shields)
over the life of the project is: $71.19 million
2. The PV of the CCA tax shield in the presence of the half-year rule
is: $16.38 million (Use PVCCATS formula!)
3. The PV of the salvage is: $35/(1+0.12)10 = 11.27 million
 Project NPV = $(-85 + 71.19 + 16.38 + 11.27) = $13.85 million!
Co
55

Financial managers  evaluate potential projects for a firm.

In Unit 6 we learned that NPV is the single best rule to use when
evaluating projects, as a company will maximize shareholder
wealth by accepting all projects that have a positive NPV.
NPV = - CF0 + CF1 +
(1+r)1
CF2
+ CF3 … +… CFn
(1+r)2
(1+r)3
(1+r)n

In this unit, we learned to identify which cash flows (whether
they are cash inflows or outflows) belong in project analysis.

Identifying the cash flows + discounting them for NPV calcs.
= Discounted cash flow (or DCF) analysis.
= Capital Budgeting.
56
7.6 Summary
DCF Analysis
 Only include incremental cash flows (not accounting profits) in
the numerator and also how to include working capital, salvage
and CCA tax shields into our analysis.

CCA does make the analysis more complicated especially if
declining balance method applies.

If you are having trouble with this Unit, try to attend one of the
Help sessions or final exam review sessions.

In the next unit, we will expand on Project Analysis by trying to
figure out how sensitive the project NPV is if our estimates of the
cash flows vary.
57
In addition to the Progress Quiz for Unit 7, you should attempt
the following Ch. 8 problems from your text:
#’s 3, 5, 11, 18, 20, 25, 27
Also, you should download and print out the Final Exam Formula
Sheet found under the ‘Other Course Materials’ folder on the
course website.
58
End of Unit 7
59